In the first cost reduction blog I explained cost reduction is lean organizations is different than traditional cost reduction practices because of method and measurement. In this blog, I want to dive deeper into material cost and machine cost to explain how lean organizations measure these cost reduction and the methods used to achieve it.
As a reminder:
Effective Measurement: Actual cost as a % sales
Goal: reduce cost as a % of sales over time
Alternative measurement for material cost: actual gross margin as a % sales
Goal: increase gross margin as a % of sales over time
To achieve material cost reduction a lean organization breaks down material cost into its components to study, learn and improve: price X quantity = cost. Let’s look at each.
Purchase price of parts
Lean organizations usually don’t seek out the lowest price suppliers because price is a function of value. Lean organizations want more out of their suppliers than the lowest price, they want their suppliers to be partners in improving material flow. Lean organizations seek suppliers who deliver the highest value in terms of quality, delivery and lead time, at the lowest price.In many lean organizations, supplier certification programs are present where suppliers must continually meet agreed upon performance requirements.
To decrease the purchase price of an individual part one of three events must occur. The part used in a product must actually change, which usually requires some form of engineering change or overall product redesign. Negotiating a lower price with the current supplier is successful or a new supplier is selected that offers the same part at a lower price (but not in exchange for bulk purchases that increase inventory!)
Once one of these 3 events occur, the difference in unit price is known. The direct cost savings for purchase price decrease is best expressed on an annual basis because material is constantly being moved through operations.
Here is calculation for direct cost savings:
- Purchase price reduction X annual part usage = annual cost savings
Supplier certification programs have the ability to lower the overall cost of the purchasing function. Poor supplier performance leads to nonvalue added purchasing activities such as expediting, reworking purchase orders and continually fixing recurring problems. Certifying suppliers will reduce these nonvalue added activities, increase the capacity of purchasing and avoid future cost increases. As a result, purchasing expenses as a percentage of sales should decrease over time.
Quantity of material
The quantity of parts purchased is function of what I call the 3 outcomes: ship, scrap or stock. Using purchased material to ship more products to customers is the desired outcome. Scrap and stocking materials are both waste.
I like to think improving quality has a multiplier effect when it comes to improvement. Improving quality reduces scrap and also improves productivity, flow and delivery.
Most manufacturing companies measure scrap expense, and sometimes it is a separate line item on an income statement. The direct cost savings of improving quality is not difficult to calculate using the improvement in the quality measure.
Here is an example of how to calculate the cost savings using the quality measure of first time through.
Annual scrap cost = $50,000
First time through rate = 70%
- First time through rate improves = 80%
- Calculate the percentage increase in first time through: 10%/70% = 14.3%
- Multiply percentage increase in first time through rate by annual scrap cost to calculate actual cost savings:
- 3% X $50,000 = $7150 annual actual cost savings
The financial impact of reducing inventory through lean practices is on the balance sheet– decrease inventory and increase cash. If your company happens to be using an internal value stream income statement material purchases will be reduced.
Here is an example of how to calculate the cost savings, using days of inventory as the performance measure.
Average materials inventory = $1,000,000
Days of Inventory = 60
- Days of Inventory improves to = 45 days
- Calculate the percentage improvement in days of inventory: 15 / 60 = 25%
- Multiply percentage improvement in days of inventory by average materials inventory to calculate cost savings:
25% X $1,000,000 = $250,000
Cost reduction of inventory management activities
Inventory is considered waste in lean organizations and it also creates a great deal of nonvalue added activities related to the receiving, inspection, movement, tracking and management of inventory.
These nonvalue added activities are performed by employees. Reducing or eliminating these activities as a result of less inventory will create capacity.
Over time these costs as a percentage of sales should decrease. Don’t overlook these cost reductions!
Machine & Equipment Costs
Lean improvement activities for machine & equipment focus around increasing the uptime or availability of a machine. For those who may not be that experienced with lean practices, this is different than utilization, which is about maximizing the amount of time a machine is used to produce parts and usually results in inventory.
Lean problem solving focuses on identifying the root causes of unavailability of a machine, which fall into two broad categories of downtime and change over time. Improvement activities related to reducing downtime are commonly referred to as total preventative maintenance (TPM) programs. Improvement activities related to change over time focus on reducing change over time and also standardizing the change-over process.
Increasing machine availability is another way to describe increasing the capacity of a machine and this will avoid increasing future costs of operating the machine.
In addition, eliminating these wastes has the added benefit of increasing the capacity for the operators of the machine (who perform change overs) and the employees that perform maintenance activities.
Some direct cost savings can also be identified, such as:
- Reducing overtime of machine operators, if machine runs overtime
- Reduction in replacement parts due to TPM
- Reduction in maintenance expense from suppliers who do maintenance work
This wraps up this blog series on cost reduction in lean organizations. The key points to take away from these blogs:
- A lean business strategy does reduce costs over time
- Measuring cost reduction in learn organizations is a combination of identifying actual cost savings and identifying how improvements avoid future cost increases
- Develop lean-focused cost reduction measures and analyses and avoid using conventional cost reduction